Tuesday, July 2, 2013

John Cochrane and full reserve banking.

Advocates of full reserve banking will approve of this article by John Cochrane (economics prof. at Chicago). The article first appeared in the Wall Street Journal.

Cochrane does not advocate full reserve as such. He concentrates on the point that bank runs (which were at the heart of the crisis) would not occur if banks were prevented from issuing what he calls “run prone-liabilities”.

That means that if depositors want to lodge a SPECIFIC SUM of money in a bank and be guaranteed to getting that SPECIFIC SUM back, then such money should be backed, in Cochrane’s words, by “short-term Treasurys or reserves at the Fed.”

In contrast, where a bank or bank-like institution wants to invest or lend on money, e.g. to fund mortgages, then that must be matched by funded by “depositors” who are essentially shareholders in the bank: that is people who hold a stake in the bank which varies with the performance of the relevant loans or mortgages.

Does that equal full reserve?

However, the latter system verges on full reserve, and for the following reasons.

To keep things simple, let’s suppose that “specific sum” deposits must be backed by reserves. And let’s suppose the private banking system goes in for a bit of fractional reserve money creation. That is private banks lend significant sums of money into existence.

That money will then be deposited back into sundry private bank accounts. And a PROPORTION of those bank account holders will want some of their money to be put into “specific sum” or ultra-safe accounts. But suppose the sum total of bank reserves is already backing “specific sum” accounts: the only way the private banking system can then keep within the law is to “unprint” some of the money it has created. That is, the private bank system would have to let loan repayments exceed “loans granted” for a while.